Public discussion on Budget 2016-17 has been dominated by the question of whether the government should stick to its fiscal consolidation path or delay the consolidation to allow for more growth-enhancing public spending.
In theory, any public investment that yields a greater social return than the cost of borrowing is worth making because the social internal rate of return (IRR) is positive. Thus, if there are enough high-quality public investments to be made, a case can be made that the fiscal deficit target should not be a sacrosanct line that cannot be crossed. In practice, bond markets simply do not trust governments to make spending decisions based on fiscally prudent IRR calculations as opposed to political considerations. Since evaluating the quality of spending on each individual public project is costly, markets use a rule of thumb for fiscal discipline and impose a sovereign-risk interest rate penalty when fiscal deficits exceed a threshold.
Evidence suggests that markets are correct to be sceptical about the quality of public expenditure. While there are anecdotal examples of ineffective spending in almost every sector, the best evidence of such inefficiencies comes from the primary education sector. Indeed, these inefficiencies are so large that there is almost no correlation between increased expenditure and improved student learning outcomes. For instance, the fiscal cost of teacher absence alone is estimated at Rs 9,000 crore each year and evidence suggests that strategies that focus on reducing inefficiencies in public spending may be over 10 times more cost effective at achieving desired outcomes than simply augmenting inputs in a “business-as-usual” way.
Similarly, recent evidence suggests that unconditional increases in public worker salaries improve employee satisfaction but have no impact on either their effort or outcomes. Further, even at current levels of salaries in India, there is no correlation between pay and productivity of public-sector workers in health and education. Thus, adopting the Seventh Pay Commission recommendations for large across-the-board increases in salaries will crowd out fiscal space for more productive investments, and there is no reason to think that these pay increases will meaningfully raise productivity in service delivery.
While these examples highlight that the quality of public expenditure is low, the deeper problem is that budget allocations to ministries and states do not reward improvements in efficiency. Line ministries today have little incentive to care about cost effectiveness, because doing more with less will typically lead to a reduction in their budget allocations. Thus, improving long-run quality of spending requires not just a one-time culling of ineffective spending (though that is a good start), but changing the architecture of fiscal decision-making to reward performance — of line ministries (by the finance ministry) and states (by the Centre).
The changes enabled by the Fourteenth Finance Commission (FFC) award and the replacing of the Planning Commission with the Niti Aayog offer an opportunity for such an approach in the social sector. They herald a major shift in the policy approach to the social sector, with a reduction in the emphasis on Centrally sponsored schemes (CSSs) and an increase in both fiscal and policy space for states to take on a leadership role in the design and delivery of social programmes. This shift presents a unique opportunity for the Centre to redirect its energies away from ensuring that states are satisfying input-based mandates of CSSs towards defining and measuring outcomes and linking to improvements a portion of Central funds to states.
One simple option would be to follow a 70:20:10 funding formula from the Centre to states based on the three principles of equality, equity and performance. Seventy per cent could be allocated on the basis of equality (same per-capita allocation across the country); 20 per cent on the basis of equity (additional allocations to states that are lagging on outcome indicators); and 10 per cent on the basis of performance. The specific percentages are only illustrative and can be fine tuned, but the main point is to allocate at least 10 per cent based on performance, which would in turn orient states towards caring about outcomes.
A key operational question is how outcomes would be defined and measured objectively. This can ideally be done by the Niti Aayog. In consultation with states, the Niti Aayog can both define the outcome goals, and be an objective entity that independently measures them. Further, the process of regularly monitoring outcomes and improvements will provide insights on which state-level policy innovations are most effective and facilitate sharing of best practices.
In any organisation, what gets measured and rewarded is what gets done, and Central and state governments in India are no exception. Indeed, the glass-half-full view of the past decade is that there have been significant improvements in almost every input-based measure of school quality, which is at least partly attributable to the measurement and monitoring of these inputs. At the same time, the glass-half-empty view is that despite these increases in inputs, outcomes on child human development measures such as malnutrition and functional literacy and numeracy are among the poorest in the world.
Pivoting the focus of government to measuring outcomes and financially rewarding improved performance will increase the policy focus on outcomes, encourage states to innovate to improve them, and enable better identification and dissemination of cost-effective best practices across states.
Several commentators have raised the concern that increasing the fiscal and policy space for states under the FFC award may lead to some states not spending enough on the social sector. However, the weak links between spending and outcomes suggest that a better approach would be to directly measure and reward improvements in the human development outcomes of interest, and let states figure out how best to improve them. While the FFC has increased the fiscal and policy space for states, the Centre still has an important role. Moving from the old “mandate and police” approach of CSSs to a new approach of “measure and reward improvements in outcomes” could play a catalytic role in improving the quality of social-sector spending (most of which is at the state level) in the coming years.
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